Citi is in talks over a $5 billion legal settlement to claims that it fraudulently sold auction rate securities to thousands of its savers, according to The Independent newspaper.

Customers were told the debt instruments were the equivalent of cash, but the collapse of the market in February left them holding securities that they have been unable to sell, according to allegations by Andrew Cuomo, the attorney-general of New York state.

The bank, already one of the hardest-hit by the credit market turmoil, is understood to be discussing a settlement that would involve it buying up to $5 billion of the frozen securities and paying a fine of around $100 million.

Mr Cuomo has threatened to bring a multi-billion dollar lawsuit against Citi unless an agreement is reached quickly. UBS, the Swiss bank which is already being sued by Mr Cuomo, is also in similar settlement talks.

A Citi spokeswoman said it had "acted in good faith and in the best interests of our clients both before and since auctions began to fail, and there is simply no basis for claims to the contrary". UBS also said it denies Mr Cuomo's allegations.

An auction-rate security is a bond whose interest rate is not fixed but set at a weekly or monthly auction, when existing holders can sell the bonds. For more than 20 years, Wall Street banks acted as market-makers, stepping in to buy the bonds at auction if demand was weak, so that holders could cash out. But amid the spiralling credit crisis, they stopped acting as buyers of last resort and since then almost 60 per cent of auctions have failed.